Goodwill

Study of the methods of valuation of goodwill and accounting treatment in case of Admission, Retirement or Death of a partner. INTRODUCTION Goodwill is the value of reputation of a firm in respect of profits expected in future over and above the normal rates of profits. It is goodwill that helps the firm to command a higher price over its competitors. Goodwill makes the firm stand out and differentiates it from the competition. It attracts customers to the firm as compared to its competitors. Such extra earning capacity of a business is because of its goodwill. Thus goodwill is the good name, good wishes or reputation of the business in the minds of all related parties like customers, suppliers, bankers, workers, etc. The reputation is created by the business due to many factors like quality of goods, relation with parties, services provided, consistency, possession of unique patent right, personal reputation of partner and many other reasons. Reconstitution of partnership means change in the relationship between the partners. In other words, it is nothing but a change in the form of partnership. Such changes can e due to new agreement among the partners. This may happen on account of 1. Admission of new partner 2. Retirement of existing partner 3. Death of partner

AIMS AND OBJECTIVES The aims for valuation of goodwill in a firm arise in the following cases:-

1. When the profit sharing ratio amongst the partners is changed. 2. When a new partner is admitted. 3. When a partner retires or dies; and 4. When the business is dissolved or sold. The objectives are as follows:1. In case of Admission:Admission of partner is a procedure for admitting a new partner into existing partnership firm as per certain terms and conditions of partnership deed. Here, incoming partner is benefiting partner and existing partners are sacrificing partners. So, benefiting partner should give a share of goodwill to sacrificing as they sacrifice their share for incoming partner. 2. In case of Retirement:From the existing partnership business if a partner wishes to leave the business, he may do so which will called as Retirement. In this case, retiring partner retires so his share of profit is divided into existing partners. That’s why, for his sacrifice it is obvious to render his share of goodwill. 3. In case of Death of partner:When any partner died in the old or existing partnership firm is called death of a partner. In such a case, deceased partner is sacrificing and existing partner advantaging partners. So, existing partner should render deceased partner’s share of goodwill to his account. METHOD AND METHODOLOGY:-\

DETAIL REPORT ON PROJECT Goodwill is the reputation created and enjoyed by firm. It generates high profits therefore the value of goodwill is calculated on the basis of profit of the concern, generally the future profit is takes into account while ascertaining the value of goodwill. The future profits of the concern are estimated on the past profits so the value of goodwill is based on future profits estimated with the help of past profits. The valuation of goodwill of the firm is made on the basis of certain methods. There are four methods for valuation of goodwill:1. Average Profit Basis, 2. Super Profit Basis, 3. Annuity Basis, 4. Capitalization Basis

1) Average Profit Basis: Under this method, goodwill is valued/ calculated at certain number of year’s purchase of the average profit of the firm. This average profit is to be considered as a base for the valuation of goodwill because a single year’s performance is not sufficient basis for judgment. Similarly it is expected that the firm will earn average profit for the next certain numbers of years and therefore goodwill is valued of certain number of year’s purchase of average point. The steps for average profit method are:1. Calculation of Total Profit

In this step the total profit is to be calculated on the basis of past few years profits and losses. While calculating the total profit, the amount of the loss of a particular year is to be deducted. Years

Amount

I

1,50,000 ( Profit)

II

2,25,000 ( Profit )

III

75,000 ( Loss)

IV

2,00,000 (Profit )

V

2,50,000 ( Profit )

The total profit will be as follows: Total Profit= (1, 50,000 + 2, 25,000 – 75,000 + 2, 00,000 + 2, 50,000) (Profits – Loss) = 8, 25,000 – 75,000 = Rs. 7, 50,000 2. Calculation of Average Profit Average profit refers to the profit earned by the firm for one year. It can be calculated by using the following formula. Average Profit =

Total Profit Number of Years

In the above example the average profit will be calculated as follows:-

Average Profit = 7, 50,000 5 = Rs. 1, 50,000/-

3. Calculation of Goodwill Under average profit method, goodwill is valued at certain number of years purchase of average profit. Thus goodwill can be calculated by using the following formula. Goodwill= Average X Number of year’s purchase Average profit as calculated in step no. 2 is Rs. 1, 50,000/and of goodwill is valued at three years purchase of average profit hen goodwill will be as under: Goodwill = Average Profit X No. of year’s purchase Goodwill = Rs. 1, 50,000 X

3

Goodwill = Rs. 4, 50,000

2) Super Profit Basis: In case of average profit basis, goodwill is calculated on the basis of average profit multiplied by certain number of years. On the other hand, super profit means, excess profit that can be earned by a firm over and above the normal profit usually earned by similar firms under similar circumstances. Under this method, the partner who gains in terms of profit sharing ratio has to contribute only for excess profit because normal profit he can earn by joining any partnership firm. Under this method, what

excess profit a partnership firm can earn is to be determined first. To value the goodwill under this method the following 4 steps are to be taken. 1. Calculation of Average profit:The procedure for the calculation of average profit is already explained above. 2. Calculation of Normal Profit:Normal profit refers to a reasonable expected profit to be earned by a business concern after meeting all its business expenses. It is ascertained by using the following formula: Normal Profit = Capital Employed X NRR 100 NRR

= Normal Rate of Return

Capital Employed:Amount of capital used by the firm to run and manage its business activities, is called capital employed. The term “Capital Employed “is made – up of fixed assets (other than goodwill) plus current assets minus current liabilities. Normal Rate of Return:Normal rate of return is the return of profit normally expected by the investors on the capital employed by considering the returns or profit actually earned by other firm in the same industry. Normal rate of return depends upon the nature of business and element of risk is involved therein.

3. Calculation of Super Profit:Super profit is the profit earned by the business concern over and above the normal profit on capital employed. It denotes extra earning of the firm. In other words, it is nothing but the excess of average profit over the normal profit. Eg. The normal earning rate of Amar & company is 155 on capital employed of Rs. 4,00,000/- therefore the normal profit or earning is Rs. 60,000/- If its actual profit or earning is Rs. 1,00,000/-, Amar & company has earned super profit of Rs.40,000 (1,00,000- 60,000) Thus super profit is calculated as per the following formula. Super Profit= Average profit – Normal Profit 4. Calculation of goodwill:Under super profit method, goodwill is valued at certain number of year’s purchase of super profit. It is calculated as per the following formula. Goodwill = Super profit X Number of year’s purchase (Obviously if there is no super profit, the firm will have no goodwill)

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TREATMENT OF GOODWILL IN CASE OF ADMISSION Goodwill means extra premium brought by new partner. There are two methods of recording goodwill in the books of accounts while admitting new partner in the existing partnership firm.

A) Extra Premium Method :Under this method incoming partner his proportionate share of goodwill in cash and it may be retained in the business or withdrawn by old partners from the business. i)

When a new partner brings his share of goodwill in cash and it is retained in the business The following two journal entries are to be passed:a) Cash/ Bank A/c………………………………………….Dr. To Goodwill A/c (Being goodwill brought by new partner in cash) b) Goodwill A/c………………………………………………Dr. To Old partner’s capital/current A/c (sacrifice Ratio) (Being goodwill retained in the business)

ii)

When goodwill is brought by new partner and it is withdrawn by old partners: The following three journal entries are to be passed:a) Cash/Bank A/c…………………………………………..Dr. To Goodwill A/c (Being goodwill brought in cash by new partner) b) Goodwill A/c……………………………………………...Dr. To Old partner’s capital/ current A/c (Sacrifice Ratio) (Being goodwill credited to old partners) c) Old partner’s capital/current A/c ………Dr. (Actual amount .

withdrawn)

To Cash/Bank A/c (Being goodwill withdrawn by old partners) iii)

When new partner bring his share of goodwill in cash & if it is paid to old partners privately:In this case no entry is required to be passed in the books of the firm, as it is a private agreement between the partners.

B) Valuation Method:Under this method new partner does not bring the amount of goodwill in cash. So old partners create/raise the Goodwill A/c in the books of the firm at the time of admission of partner. The following is the accounting treatment of goodwill as per this method. i)

When the new partner does not bring the goodwill in cash and it is raised in the books of the firm: The following journal entry is passed. d) Goodwill A/c……………………………………………...Dr. To Old partner’s capital/ current A/c (In old Ratio) (Being goodwill credited to old partners)

ii)

When Goodwill is raised and written off: The following two journal entries are passed.

a)

Goodwill A/c……………………………………………...Dr. To Old partner’s capital/ current A/c (In old Ratio) (Being goodwill rose in the books of the firm)

b) All partners’ capital/current A/c ………Dr. (in New profit sharing .

ratio) To goodwill A/c (Being goodwill written off)

iii)

When goodwill already appears in the books of the firm: In such case, if the goodwill is revalued, the entry is passed for the amount of difference either through capital/current a/c or revaluation a/c.

TREATMENT OF GOODWILL IN CASE OF RETIREMENT AND DEATH The goodwill is shown, valued, raised or adjusted in the books at the time of retirement and death of partner in the following different way. i)

If goodwill is raised to its full value and retained in the business Goodwill A/c…………………………………………………Dr. To All Partner’s capital A/c (Being full value of goodwill is distributed to all the partners in old profit sharing ratio)

ii)

If goodwill is fully raised and then written off a)

Goodwill A/c…………………………………………………Dr. To All Partner’s capital A/c (Being goodwill created and credited to all partner’s capital

account in their old ratio) B

continuing partner’s capital A/c………………Dr.

To goodwill A/c (Being raised goodwill written off and debited to continuing partner’s capital account in their new ratio) iii)

If goodwill is raised to the extent of retiring partner’s share only and retained in business Goodwill A/c………………………………………Dr. To Retiring partner’s capital A/c (Being share of goodwill of retiring partner to the credited to his capital A/c)

iv)

If goodwill raised equal to the retiring partner share earlier and now written off: Goodwill A/c………………………………………Dr. To Retiring partner’s capital A/c (Being share of goodwill of retiring partner to the credited to his capital A/c)

Continuing partner’s capital A/c……………..Dr. To Goodwill A/c (Being the share of goodwill of retiring partner is to be written off in gain ratio) OR Continuing partner’s capital A/c……………..Dr. To Goodwill A/c

(Being the share of goodwill of retiring partner is to be written off by continuing partners in gain ratio) V)

If goodwill is given in the old balance sheet. The net result of its

revaluation may be shown either in profit and loss adjustment account or shown in partner’s capital account.

CONCLUSION When a new partner is admitted into a partnership, certain adjustments in accounts become necessary. Chiefly, this is because the new partner will acquire a share in the profits of the firm and because of this; the old partners will stand to lose. Goodwill is compensation to old partners for their sacrifice in connection with admission of a new partner. So it is to be credited to the partners according to their profit sacrificing ratio. Whatever shares the new partner is getting, it may be sacrificed by the old partners in proportion to their old profit sharing ratio or in different proportion. In case of Retirement of a partner, the continuing partners will gain in terms of profit sharing ratio. Therefore, they have to pay to retiring partner for his share of goodwill in the firm in the gaining ratio. Similarly, in case of death of the partner, the continuing partner should bear the share of goodwill due to the heirs of the deceased partner. For this purpose, the goodwill is valued on the date of the retirement or death and adjusted through the capital accounts of the partners.

YOUR OPINION AND SUGGESTION Whatever there is any change in the existing relationship of the partners inter se, some partners have to sacrifice their future profit

and some others would gain. Those who are sacrificing future profit should be compensated by the others who are gaining. This adjustment of the partnership rights may arise due to admission of a new partner, change in the profit sharing ratio, retirement or death of a partner and dissolution of the partnership. The partners, who gain in terms of profit sharing ratio, have to pay for such gain as a proportion to the value of goodwill. The partners, who lose in terms of profit sharing ratio, receive payments for the sacrifice as a proportion to the value of goodwill.

REFERENCES 1) Book-keeping and Accountancy standard XII Maharashtra State Board of Secondary and Higher Secondary Education 2) Fundamentals of Accounting Board of Studies, The Institute of Charted Accounts of India